Getting The Real Earnings

Earnings, otherwise known as net income or net profit, represents the money that's left over after a company pays all of its bills. For many investors, the growth of a company's earnings is the most important factor when analyzing a company. It's often used as a gauge of profit performance.

Knowing a company's earnings growth is important; however, it is a bit pointless if the growth is generated not by sales but by new share capital issued for cash. Profit can be therefore be determined more accurately through a close examination of changes in earnings per share (EPS) and diluted earnings per share. By taking into consideration the size of a company's increased capital base, changes in EPS provide a far better view of a company's fundamentals and changing fortunes. (Learn more in Everything Investors Need To Know About Earnings.)

EPS Says MoreThe best way to explain the importance of EPS is with an example. Let's say Tricky Inc. reported year-end earnings of $12 million. It also boasted an outstanding 50% net earnings increase from the previous year's $8 million in earnings. Without question, that would have been an outstanding result had the increase been made using the same amount of capital as in the previous year. But it wasn't.

Over the year, Tricky Inc. acquired numerous businesses that were paid for by issuing new shares to the sellers. Shares on issue, as a result, increased by 25% from 100 million to 150 million. So, while earnings increased by 50%, this was largely due to the profits from the acquired businesses that were funded from the increased share capital. Therefore, Tricky Inc.'s profit improvement was far less than it appears. By examining changes in EPS - which, as we mentioned above, takes into account increases in capital base - we can see the real extent of Tricky Inc.'s "profit" growth. (Learn more in Earnings: Quality Means Everything.)

Calculations Are Not So SimpleAll listed companies are required to report EPS in their financial statements. But calculating EPS is not quite as simple as dividing earnings by the number of shares on issue at the balance date. If the number of shares on issue has changed during the year, you need to account for how much of the year they were on issue and calculate the weighted average number of shares on issue during the year.

Let's take another look at Tricky Inc. On Jan 1, 2003, it had 100 million shares on issue. On Mar 31, it issued 50 million additional shares. So, for nine months of the year there were 150 million shares. Therefore, the weighted average number of shares as reported by Tricky should be (100 shares x 1/4 year) + (150 shares x 3/4 year) = 137.5 shares.

Now we can calculate the EPS. For the year, Tricky Inc. earned $12 million per 137.5 million shares, or 8.7 cents per share. That's not much higher than the previous year's EPS of $8 million per 100 million shares, or 8 cents a share.

Now that we've determined its EPS, Tricky Inc.'s performance doesn't look quite so outstanding. Although the company announced that earnings rose by 50%, its earnings per share grew by a less impressive 8.75% ([8.7 -8]/8).

Diluted EPSAnother number that goes a long way towards revealing a company's true state of affairs is diluted earnings per share, which is also measured as net income divided by the average number of shares on issue during the period. But diluted EPS takes into account shares that might be issued in the future as a result of, say, the exercise of options.

Let's say Tricky Inc. had a total of 20 million options on issue with an exercise price of $2.50 and exercise date coming up. Tricky Inc. shares are trading at $3 per share. Because the options are priced at a 50-cent discount, the possibility of dilution is real. So, we should include the impact on EPS. Diluted EPS is calculated as $12 million earnings/170 million shares, or 7.1 cents per share.

Diluted EPS is important because it accounts for the cost to shareholders of options and other securities than can affect the number of outstanding shares. For more on the cost of employees stock options for companies see the feature Accounting and Valuing ESOs.

ConclusionAs they don't adjust for new share issues and takeovers, earnings figures on their own do not tell investors nearly enough about performance fundamentals. An absolute increase in net income is not in itself an adequate indicator because net income may go up as a result of increased investment. More investment will certainly generate additional earnings for the company, but for investors like you and me, the real question is whether growth in earnings compensates for more shares.